Low interest rates may cause financial instability – IMF

MANILA, Philippines - Governments and private enterprises have benefitted from the low interest environment abroad which allowed them to borrow funds cheaper, but continuation of the trend may cause financial instability, the International Monetary Fund (IMF) said.

“At present, balance sheets within emerging markets appear generally sound, but a continuation of current trends would likely lead to an increase in financial stability risk,” IMF said in its latest Global Financial Stability Report.

Interest rates at floor levels abroad— partly caused by an effort to boost growth— have not only push out funds from Europe and the US, it also encouraged states and firms to source funding abroad.

By the IMF’s estimates, foreign-currency borrowing by emerging market businesses rose by an average of 50 percent in the past five years. For sovereigns, the agency said dollar purchases reached “new highs.”

While low borrowing rates are welcome, the multilateral agency warned an increase in foreign exchange funds must be matched by a rise in issuance of investment assets to absorb these inflows.

It noted most foreign funds have been finding their way to the government bond market, shunning equities because of their risky characteristic. Corporations, on the other hand, have refrained from floating bonds themselves.

With low issuance and large influx of foreign investors, asset bubbles, while still absent in emerging markets, should now be a cause of worry for policymakers.

The fear is that a repeat of the 1997 Asian financial crisis may happen, when stock markets around the region crashed, denting growth and causing economic turmoil later on.

“While emerging markets benefit from favorable external financing conditions, including through reduced borrowing costs and a wider range of financing sources, excess borrowing could increase risks in the medium term,” the IMF explained.

“At the same time, the crowding-in of foreign investors could lead to an asset price bubble, with prices becoming increasingly sensitive to external conditions,” it added.

In addition, economies should watch out for a possible rise in interest rates— or an “interest rate shock”— in developed markets which could push up the amount of their foreign financing.

Funds flowing to emerging markets have contributed to the rise in credit in these economies. According to the IMF, the proportion of credit to gross domestic product (GDP) is about 70 percent.

Credit-to-GDP ratio is a gauge to measure if the amount of credit flowing in the system is enough to finance growth or excessive that it could stoke inflation and cause asset bubble formation.

The IMF said while the emerging markets credit ratio remains far behind that of advanced economies, at 140 percent, policymakers should be watchful of sustained inflows.

“Low interest rates and favorable financing conditions have eased risks and supported growth in emerging markets, but prolongation of such condition will likely lead to the build-up of vulnerabilities and potential stability,” it said.